Sunday, November 16, 2008

Either the markets are right and the end of the modern world as we know it is right around the corner, or corporate bonds and stocks are absurdly, grossly and egregiously undervalued. I say that because the pricing today of corporate bonds and stocks assumes that we are entering a period that will be significantly worse than what occurred during the Great Depression of the 1930s.

At the risk of simplifying a complex subject, the Depression was largely the result of a massive contraction of the banking sector and money supply, a massive contraction of world trade set in motion by the Smoot-Hawley Tariff Act of 1930, a massive increase in government intervention in the economy, and a massive increase in taxes meant to offset a similarly massive increase in government spending. 1929-1933 was by far the worst period. The economy shrank by 26.5% in those four years, and prices on average fell by 25%. This was a nightmare for anyone with debt, since economic activity collapsed and dollars became much more expensive to acquire. By 1936, the peak year for cumulative defaults, about 14% of all corporate bonds were in default, according to the National Bureau of Economic Research, making it the worst corporate bond disaster in U.S. history.

According to Lehman data, the current level of spreads on investment grade bonds implies that about 9% will be in default within five years, and fully 70% of speculative-grade bonds will be in default. That further implies that 24% of all corporate bonds currently outstanding will be in default within 5 years. If only 14% of firms defaulted on their debt during the depths of the depression, what sort of economic conditions would it take for almost one-fourth to go out of business?

Tim Bond, an economist at Barclay’s Capital in London, has calculated that the current level of spreads on corporate bonds (which is by far the highest ever recorded—600 bps on investment grade, and 1700 on high-yield bonds) implies 3-4 years of a 15% annual contraction in GDP. That would be about twice the average 7% annualized rate of contraction during the worst period of the Great Depression, 1929-1933.

According to my model of equity valuation, which I have discussed here, and which is a variant on the Fed Model and Art Laffer’s model, the stock market is assuming that corporate economic profits (as calculated in the National Income and Product Accounts) decline by at least two-thirds over the next few years. In relation to GDP, that would put them 25% lower than the worst period (1974) since they were first measured (1959).

Any way you look at it, the pricing on corporate bonds and stocks today implies that the next several years will be the most disastrous in the history of the U.S.

In order to fully appreciate why that prediction is unlikely to prove correct, consider that not one of the key ingredients that precipitated the depression exists today. Although we do have a banking crisis, the Fed has taken incredibly aggressive steps to prevent a monetary contraction or deflation from occurring. Indeed, as I have noted repeatedly, there is more money and bank lending in the world today than ever before. World trade has expanded greatly since the depression, and an outbreak of widespread protectionism in the near future seems like a very remote threat. We have had some meaningful increases in government spending, but so far we have not seen any attempt to raise taxes.

For the market's fears to be realized, I think the Obama administration would have to make just about every conceivable mistake in this regard, and not only quickly but massively. If that doesn't happen, then this is the buying opportunity of a lifetime.

20 comments:

The real question is whether or not stocks go meaningfully lower from here. If uncertainty increases and experiments are used to restore confidence we could see fear drive prices lower, not just fundamentals.

I think it is time to reduce non-U.S. exposure generally, as well as reduce U.S. equity exposure regardless of losses realized, and move to an LB Agg type of portfolio for the next several months while we see what policies and consensus views develop, if any.Does fundamental analysis even work in this environment?

cdlic: If there were no hope, then I would sell whatever I could, buy an island in the S. Pacific, stock it with plenty of guns and ammo and enough food for 5 years, and depart the U.S. asap.

Barring that rather drastic course of action, I would seriously consider investing in TIPS, where you can lock in a 3% return plus inflation. That is, if the US government continues to honor its promises.

Gold is already pretty expensive, and it doesn't pay interest. There's no currency that I'm aware of that is particularly cheap.

The options available if you are extremely pessimistic are very limited.

Casual: You have a good point, but from a long term perspective, whether stocks hold these levels or fall another 10% is not going to make or break you if you decide to buy stocks today and they end up moving significantly higher over the next several years.

The level of fear can certainly increase, but it is already extremely high. That's why I think that if you have any confidence at all in the long run viability of the US political system and the US economy, you just have to be invested in stocks and corporate bonds and be prepared to suffer some more pain.

Non-treasury bonds are not necessarily a bad thing, since spreads are pretty high across the board. With bonds you have the advantage of earning a pretty healthy interest rate even if things remain miserable and stocks fail to advance. I would recommend a LB Agg portfolio without the treasury component. Who needs Treasuries when yields are 2-3%? There is very little upside to owning Treasuries and a lot of downside, especially if Obama decides to ramp up infrastructure spending and the Fed's quantitative easing gains more traction.

Assuming fear is the primary factor for the depressed prices (bonds and equities), isn't there the implication that such fear includes the vast majority of investing Americans? And, wouldn't such a majority include folks in all political arenas? So isn't there an implied indicator that the folks who voted for and aggressively supported Obama are now in the "fear" camp along with those who supported McCain/Palin?

I am not sure that these calculations which "imply" certain assumptions about earnings or default levels make sense. Human valuations, after all, are subjective and money prices for securities (or anything else) depend on human valuations of both money and the "goods" in question.

The quantity of dollars used to purchase securities has been wildly bolstered in recent years by extreme leverage, with hedge funds sometimes leveraged 30:1. If this is now changing, and people are beginning to deleverage themselves, the demand expressed in dollars might fall steadily.

The low prices, in that case, would not imply that people are actually assuming such dire economic results. The low prices, instead, would come from the simple fact that demand is falling and people are now valuing dollars higher relative to the securities -- because they want to (or must) pay down debt.

The yield fundamentals might scream "good deal" but it's not at all clear that prices will soon rise again to levels that were attained only thanks to highly leveraged speculation - with much of that leverage coming from monetary inflation, not savings.

As for security prices, I think it is interesting to look at the Nikkei. If someone had bought the Nikkei at any moment in the last 20years (other than the very bottom in 2003), they would be under water to this day.

As to the potential for a depression, I would say that the government has so far done absolutely everything wrong and there are ample indications that we will soon see public works programs, unemployment insurance extensions, more bailout payments to insolvent companies, mortgage forgiveness programs, politically directed energy "investments" and all the rest. The extreme liquidity programs from the Fed are not a positive development, either. All of these interventions will tend to prevent the accumulated malinvestments from being liquidated. And many of these interventions will be training entrepreneurs that the way to wealth is to have a good lobbyist.

The US economy recovered after WW II because the government finally remooved price controls and production constraints -- and the soldiers came home and began productive careers. The relaxation of controls was not a sure thing; there were "big" people in the US, like John Kenneth Galbraith, who opposed that action.

I wonder if we will similarly be able to overcome today's Paul Krugmans and other blithering "economic" idiots? Perhaps so, but making that assumption does take a certain amount of faith. I see not a single contemporary political heavy weight who has a free market orientation.

It seems to me like betting some assets on a US revival makes sense, but to bet the farm would require a blind faith unwarranted by the facts.

For your notion to be correct (I'm not suggesting that it isn't correct) wouldn't the hedge fund managers that are de-leveraging back to normalcy have to "control" or "constitute" the major part of the market?

Gene: I wouldn't be surprised to learn that some Obama voters who are also investors have buyer's remorse. The hopes that have been pinned on this one man seem almost sure to be dashed. And if he is determined to do everything he promised, then there is reason to be worried.

Tom: you are the resident bear, that's for sure. The valuations out there are undoubtedly driven by fear, but since they are also consistent with an end-of-the-world-as-we-know-it scenario, I wanted to make that point clear. You can essentially quantify the type of scenario these fears are representing.

Deleveraging is also undoubtedly a factor driving the relentless selling. To the extent it is, that is simply a call to arms for those who are optimistic enough to think we can avoid a deep depression.

Your despair is most likely shared by millions of investors these days.

Red: I'm betting they don't do all the things they have promised. They won't pursue an aggressive far-left agenda. They are going to find that it is much easier to criticize than it is to come up with policies that have a chance of improving things.

I note that Al Gore recently backed away from his call for a carbon tax, and that is a positive for the economic outlook.

For sure I am bearish compared to many people. I do not think that current prices reflect an "end of the world as we know it" scenario. John Hussman, in his column this week, has opinions that are fairly close to yours. But as part of his optimism, he shows that current market parameters are well within historic norms. To get into the bottom 5% of historical S&P 500 valuations, for example, the SPX would have to fall to 625. I think you might agree with Hussman's current views.

Bearish as I am, I also agree with the general thrust of Hussman argument, and I am slowly buying into stocks that seem to have particularly good values. I haven't sold anything except at much higher prices - before the current "crash." Maybe that will moderate to way you see my state of mind?

The problem that concerns me is not that the world as we KNOW it is ending, but that it seems increasingly likely we are not soon going to get BACK the world that gave us our prosperity. The world as we once knew it has been gone for a while and we are now reaping the "rewards" for that loss.

Much of the last decade or two has been a fraud -- and our government seems to continue driving nails into the free market coffin. If this trend continues, it could take longer than I have for the US to get back to a solid economic basis. Even as I mourn that loss, however, I recognize that stocks of excellent companies will probably still provide good returns, so I am buying selectively.

To Gene's point: it's not just the hedge funds that are deleveraging, it's the banks and the investment banks, along with countless private individuals. It's not just explicit margin loans that are relevant to this process. And remember, prices are set at the margin. I think the recently posted article by Michael Lewis ("The End") is relevant as we think about our recent "investment" markets and pricing of financial assets.

Scott: Thank you for your excellent blog. I think your optimism about the current values in the U.S. stock market is fully justified. President-elect Obama is likely to be far kinder to investors than people fear.

tom: here's a thought. If all that ails the stock market is hedge funds and others unwinding positions and deleveraging, that would be very bullish in my view. Sooner or later they will finish, and the selling pressure will subside.

My friend, Dennis, read this post and commented as follows. What are you thoughts regarding his comments? By the way, Dennis has spent the last 32 years and figured out why Civilizations fail and how to prevent this in the future.

CDLIC,

This analysis is good as far as it goes but for me it fails in the end since it does not account for several major factors that are very much with us: (1) the runaway Federal spending which is now on course to clock in at a $1T deficit for 2009 and (2) the soon to hit Social Security tsunami of the baby boomers who have paid in extra funds for the last 20 years but are going to learn that the money has already been spent by Congress. Thus to handle the situation Congress will have to cut spending by $T plus whatever it takes to handle the added load on Social Security and this is just not going to happen. If it should by some miracle happen, it would bring on a great depression since about half the population now sucking down at the Federal trough would be out on the street looking for work— or more likely rioting. Congress is now destroying the dollar in a futile attempt to put off the day of reckoning. We really have no idea where we are at and it will be at least a generation after all the defaults until we can know again where we are at. Obama is adding fuel to the fire by setting up expectations that Big Brother will be soon handing out even more goodies to more folks.

CDLIC: I worry about government spending, deficits, and entitlements a lot. But I don't think they are going to cause a depression or force us to wipe out the dollar's value.

Spending just keeps going up, but it hasn't gone up much faster than nominal GDP. Spending today as a percent of GDP is only slightly more than it has averaged over the past 30 years. See my post of Fiscal Policy recap for a chart. Spending and deficits always increase in a recession, and this is one is no exception to the rule, nor do things look significantly worse than at other times of recession.

The problem with Social Security can be fixed several ways. The government can 1) raise the retirement age, 2) reduce benefits, 3) means test benefits, 4) index benefits for inflation instead of for real incomes, and 5) increase SS taxes. I predict the first four will happen.

Congress does not control the dollar. The Federal Reserve does, and the dollar is not outside the bounds of the valuation range it has seen since Nixon took us off the gold standard (curse him!).

As for Obama, he has indeed created a potential problem by convincing people that he has magical solutions to problems that have confounded policymakers for generations. Expectations are so high that he is almost certain to disappoint. But that doesn't mean a depression either.

I see lots of things in our country that could be improved, but I don't think we need to rebuild from scratch.